FactorLaw's Summary and Analysis of the Small Business Reorganization Act

1. THE SUBCHAPTER 5 ELECTION. Chapter 11 now contains a “Subchapter 5” which applies only to “small business debtors” that make a so-called “Subchapter 5” election. See 11 U.S.C. §§ 1181-1195. Absent such an election, the small business case will be administered under the existing small business provisions of Chapter 11. Although the 2005 BAPCPA amendments to the Bankruptcy Code streamlined the Chapter 11 process for small business debtors (i.e., a plan has to be confirmed within 300 days), the process was still viewed as too onerous and expensive for those that qualified. Subchapter 5 provides small business debtors the option of using a new law designed to make the chapter 11 process faster and cheaper, including the process for selling a distressed business under a plan. It brings to Small Business Cases under Chapter 11 features previously available only in Chapter 12 or 13 cases. SBRA also reshuffles the leverage between debtors and creditors and tries to promote consensual outcomes.

2. THE INTERIM BANKRUPTCY RULES. Interim amendments to the Federal Rules of Bankruptcy Procedure also have been promulgated to guide cases where the debtor has made the Subchapter 5 election. The interim bankruptcy rules, including Interim Bankruptcy Rule 1020, implement the SBRA. New forms also may be forthcoming.

3. MAKING THE ELECTION. The Subchapter 5 election must be made on the petition for relief for voluntary cases or within 14 days after the order for relief in involuntary cases. Although the Subchapter 5 election is made when the bankruptcy petition is filed, Rule 1020(b) suggests the petition can be amended to make the Subchapter 5 designation after the filing. Doing so may not be advisable, however, because a delayed election may cause key deadlines to be missed. Another potential issue involves the retroactive application of the SBRA to cases pending before its effective date.

4. ELIGIBILITY CRITERIA. Subchapter 5 cases are available to any entity or individual engaged in commercial or business activity with aggregate and liquidated debts of not more than $2,725,625, of which more than 50% is commercial or business debt. The new law helps clarify eligibility. More than 50% of the debt has to be commercial or business. In view of SBRA’s changes to the absolute priority rule, inter alia, individual chapter 11 debtors with primarily business debts should consider whether they can make the Subchapter 5 election. The eligibility requirements to be a small business debtor have been modified insofar as more than 50% of the debt now must be from the commercial or business activities of the debtor and the exclusion for single asset real estate debtors has been clarified.

5. CRAMDOWN VS. CONSENSUAL PLANS: SBRA differentiates between confirmation under §1191(a) and 1191(b). Section 1191(a) deals with a plan that is accepted by all classes of claims – i.e., a consensual plan. Section 1191(b) addresses a “cramdown plan.” As discussed herein, certain SBRA provisions apply, or do not apply, depending upon whether the plan is consensual or not. Existing law differentiates between a consensual plan and a cramdown. However, the requirements to confirm a cramdown plan are essentially the same as the requirements for a consensual plan, other than the absolute priority rule. The SBRA eases the burdens for confirming a cramdown plan and thus provides debtors with more leverage to negotiate concessions from creditors. Conversely, debtors fare better under SBRA if they are able to negotiate a consensual plan. As discussed herein, the SBRA tries to foster consensual plans.

6. NO ABSOLUTE PRIORITY RULE. Like in Chapter 13, the absolute priority rule does not apply with respect to classes of unsecured creditors when the debtor makes the Subchapter 5 election. Thus, the owners of the business can retain their ownership interest even if unsecured claims are not paid in full. Similarly, an individual debtor can retain property even if they do not pay unsecured creditors in full. Secured creditors, on the other hand, still must be paid in accordance with §1129, but like before, their claim can be bifurcated into a secured and unsecured portion. Also, secured creditors can still make the §1111(b) election. Prior to SBRA, the owners of a small business debtor could not retain their ownership interests unless all creditors, including unsecured creditors, were paid in full. Similarly, an individual that qualified as a small business debtor could not retain any property absent payment in full of all creditors. Paying creditors in full prior to allocating value to equity was codified in the “fair and equitable” test of §1129(b), which also codified the absolute priority rule. The absolute priority rule is a long-standing requirement of chapter 11 and in the past could be a strong impediment to the confirmation of a plan. Under SBRA, to be “fair and equitable” as to unsecured creditors, the small business debtor now is obligated to pay all of its projected disposable income for the duration of the plan (which is either 3 or 5 years). Disposable income is income that is not necessary for maintenance or support of the debtor or dependents of the debtor, domestic support obligations, and payment of expenditures necessary for the continuation or preservation of operation of the debtor’s business. In other words, the SBRA specifies that a plan still meets the fair and equitable test even if it allocates value to equity without paying unsecured creditors in full, so long as it meets the alternative definition of “fair and equitable set forth above. In this way, the SBRA does away with certain aspects of the absolute priority rule.

7. ADMINISTRATIVE CLAIMS. If the plan is not consensual, the debtor can pay administrative claims over the life of the plan (i.e., 3 to 5 years). The option to stretch out administrative claims is not available for consensual plans. Under existing law, all administrative claims, including attorneys’ fees, have to be paid at confirmation. Often a Chapter 11 debtor cannot confirm a plan because they do not have sufficient funds to pay all administrative claims in full on the confirmation date. Paying such amounts over 3-5 years (depending upon the length of the plan) facilitates confirmation of the plan. Allowing payment of such claims over the life of the plan also limits an administrative claimant’s ability to block plan confirmation. Restricting to nonconsensual plans the ability to extend payment for administrative claims can create an anomaly.

8. MODIFYING HOME MORTGAGE CLAIMS. SBRA allows a plan proposed by a small business debtor to modify a claim secured by the debtor’s principal residence so long as the mortgage was not used primarily to purchase the residence and the new value received in connection with the granting of the security interest was used primarily in connection with the debtor’s small business. Under chapter 13 and chapter 11, a debtor cannot modify a claim secured solely by the debtor’s principal residence. Claims secured by the debtor’s principal residence and other collateral were outside the scope of this restriction. Consistent with its goal of shuffling the leverage calculus between debtor and creditor, the SBRA now allows a small business debtor to modify a mortgage on their residence that was granted to secure a guaranty or that was granted to secure a line of credit used to provide business liquidity. This aspect of the law helps tilt the scales more towards the small business debtor because under prior law a claim secured by the debtor’s principal residence was almost sacrosanct.

9. NO DISCLOSURE STATEMENT. The SBRA eliminates the need for a disclosure statement to accompany a plan, unless the court orders otherwise. However, the plan must include a liquidation analysis, a brief history of the business operations of the debtor and projections with respect to the debtor’s ability to make the proposed plan payments. Existing law requires a disclosure statement for a plan and prohibits a debtor from soliciting votes on a plan absent dissemination of a disclosure statement that has adequate information. Existing law also permits the court to hold a combined hearing on the plan and disclosure statement for small business debtors. The elimination of the disclosure statement reduces cost and expense. Additionally, § 1125 does not apply in Subchapter 5 cases and thus votes can be solicited even if the court has not approved a disclosure statement, although the court can enter an order requiring a disclosure statement.

10. NO ACCEPTING IMPAIRED CLASS. The SBRA strikes the need for an accepting impaired class to cramdown a plan. Under existing law, if a plan impairs the claims of creditors, it cannot be confirmed unless at least one impaired class of unsecured claims accepts the plan, without considering the votes of insiders. This requirement poses a sometimes insurmountable obstacle to confirming a cramdown plan. Section 1129(a)(10), which requires an accepting impaired class for cramdown, does not apply to debtors that make the Subchapter 5 election. This change in law is another example of how the SBRA is designed to facilitate confirmation of a plan and to rearrange the leverage between debtors and creditors.

11. NINETY DAYS TO FILE A PLAN. If the debtor makes the Subchapter 5 election, it must file a plan on or before 90 days after the petition date. Also, only the debtor has the right to file a plan and to modify the plan. Under existing law, a small business debtor has the exclusive right to file a plan within the first 180 days and must obtain confirmation within 300 days of the petition date and not later than 45 days after filing the plan. Requiring a plan within 90 days of the petition date and eliminating a creditor’s ability to propose a plan, are designed to expedite the chapter 11 process. If the debtor does not file the plan within the 90 day period, the failure can be excused only if the court determines the failure is attributable to circumstances for which the debtor should not justly be held accountable.

12. THE STANDING TRUSTEE. If a debtor makes the Subchapter 5 election, a standing trustee automatically supervises the case. The standing trustee functions as an advisor or overseer of the process and is more akin to the Chapter 13 trustee than a Chapter 7 trustee. The U.S. Trustee’s office has indicated it has, or will be, appointing standing trustees with expertise in financial management and accounting. One of the standing trustee’s express responsibilities is to “facilitate the development of a consensual plan of reorganization.” §1183. Under existing law, a Chapter 11 trustee can be appointed only for wrongdoing or mismanagement by the debtor in possession. Additionally, if a trustee is appointed for cause, they oust the debtor in possession and have primary responsibility for operating the business and fulfilling the duties of a debtor in possession. The standing trustee in a Subchapter 5 case is not focused on operating the debtor’s business but on helping the debtor and other interested parties reach a consensual resolution of their issues. The U.S. Trustee’s office has suggested they do not want the standing trustee to usurp the role of the debtor’s attorneys and want to limit administrative claims by discouraging the standing trustee from retaining counsel.

13. EXCLUDED BANKRUPTCY CODE PROVISIONS. Multiple provisions of the Bankruptcy Code do not apply when the debtor makes the Subchapter 5 election. These consist of §§ 105(d), 1101(1), 1104, 1105, 1106, 1107, 1108, 1115, 1116, 1121, 1123(a)(8), 1123(c), 1127, 1129(a)(15), 1129(b), 1129(c), 1129(e), and 1141(d)(5). Additionally, certain provisions do not apply “unless the court for cause orders otherwise.” These provisions consist of paragraphs (1), (2), and (4) of § 1102(a) and §§ 1102(b), 1103, and 1125. The rights and duties imposed by the excluded provisions either do not apply at all or apply in a modified form under a specific section of the SBRA. For example, although § 1116 is an excluded provision, § 1187 of SBRA provides that § 1116(1) applies upon the Subchapter 5 election and the debtor “shall comply with” the remaining provisions of § 1116. Because of the statutory framework of the SBRA, the changes to existing law are not immediately apparent and thus practitioners should be careful about understanding the changes to existing law.

14. THE STATUS CONFERENCE. SBRA requires a status conference no later than 60 days after the petition date. At least 14 days before this conference the debtor must file a report containing an outline of efforts they have taken and will take to confirm a “consensual plan of reorganization.” Under existing law bankruptcy courts usually set an initial case status conference. Directing the debtor to disclose early in the case its strategy for reorganizing fosters communications and negotiations with creditors. It also highlights the fast-paced nature of the proceeding.

15. TIMING OF DISCHARGE. The debtor does not obtain a discharge until the end of the plan period, which can be up to 5 years, except if the plan is consensual, in which case the discharge is entered on confirmation. The standing trustee also is relieved of their duties upon substantial consummation of the consensual plan. Under existing law, § 1141 discharges the debtor upon confirmation, except that individual debtors do not obtain a discharge until they have completed plan payments. Allowing discharge upon confirmation for consensual plans is another mechanism for fostering negotiation with creditors and agreement with stakeholders. This provision also can undermine post-confirmation financing efforts because of lender hesitancy to loan to a business that has not received a discharge.

16. CHANGES TO PROPERTY OF THE ESTATE. SBRA modifies the scope of “property of the estate” depending upon whether the plan is consensual or not. For a cramdown plan, estate property includes earnings and property acquired postpetition and post-confirmation until the case is closed, dismissed, or converted. For consensual plans, the property of the estate is limited to that which existed as of the confirmation date. Under existing law, postpetition property is not part of the bankruptcy estate, except when the debtor is an individual. For individual debtors, §1115 extends the definition of property of the estate to property acquired up to the time the case is closed and includes earnings from services performed prior to case closing. SBRA states that §1115, which deals with postpetition earnings for individual debtors, does not apply generally to a Subchapter 5 case. Instead, §1186 of SBRA states that if the debtor confirms a non-consensual plan, property acquired after plan confirmation is part of the estate. Section 1186 offers another incentive to reach a consensual plan.

17. NO CREDITORS’ COMMITTEE. Unless the court orders otherwise, a creditors’ committee is not appointed when the debtor makes the Subchapter 5 election. Under existing law, a debtor cannot be a small business debtor if a committee is appointed. Section 1102 also provided that a court may order a committee not to be appointed. SBRA excludes committees because it seeks to foster faster and less expensive cases and because the standing trustee can perform most duties normally assumed by a creditors’ committee.

18. CHANGES TO §327. Lawyers or accountants owed less than $10,000 by the debtor are not disqualified from employment under §327. Under existing law, attorneys or accountants owed any sums by the debtor were creditors and thus not disinterested. They thus had to choose between writing off the debt or not representing the debtor in the bankruptcy proceeding. SBRA allows professionals to get prepetition invoices up to $10,000 paid under the plan. Eliminates the need to write-off such amounts to satisfy the disinterestedness requirement.

19. PREFERENCE SUIT VENUE CHANGES. Preference suits of less than $25,000 have to be filed where the defendant is located. Existing law provides that preference suits of less than $10,000 have to be filed where the defendant is located. The new law is designed to protect small businesses that did business with a debtor by making it more difficult to sue them in distant venues (e.g., Delaware or New York) for a smallish preference.

20. POST-PETITION PAYMENTS. Under SBRA, the court “may authorize” the standing trustee to make adequate protection payments after notice and a hearing. Additionally, if the debtor confirms a cramdown plan, then the trustee shall make the plan payments, except to the extent the plan provides otherwise. If the plan is consensual then the debtor makes the plan payments. Under existing law, the debtor can be ordered to make adequate protections payments. Further, existing law generally provides that the debtor will disburse all plan payments. For cramdown plans, the trustee stays involved during the life of the plan. This provides another incentive for the debtor to work out any conflicts with creditors to achieve a consensual restructuring. Similarly, the trustee’s role in making adequate protection payments suggests they will have at least some, and potentially a large, involvement in the debtor’s use of cash post-petition.